How a GRAT can help you reduce estate taxes

If you're looking to pass assets to your heirs while reducing your exposure to estate taxes, a Grantor Retained Annuity Trust (GRAT) can be an effective strategy in your estate plan.

A GRAT allows you to move appreciating assets, usually shares of stock, out of your estate into an irrevocable trust. You’ll receive regular annuity payments for a specified time (e.g., 10 years) from the trust. The assets left at the end of the trust term pass to your beneficiaries with little or no estate or gift tax liability.

Who can benefit from a GRAT?

There are four criteria that can help determine if a GRAT makes sense for you:

1. You expect to be subject to estate tax. If your estate exceeds the federal estate tax exemption ($13.61 for individuals, $27.22 for couples in 2024), any assets above this amount will be subject to a 40% estate tax, so you want to move assets out of your estate to limit your exposure to gift and estate tax.
2. You expect the federal estate tax exemption to decrease in 2026. Under current law, the enlarged federal estate tax exemption is scheduled to “sunset” at the end of 2025. If legislative action is not taken, the result will be a federal estate and gift tax exemption amount about 50% less than what it is today. In other words, we may be in a “use it or lose it” situation with respect to the currently super-large estate tax exemption.
3. You have stock or other assets that you expect will appreciate. A GRAT works best if you can fund it with securities that you expect will appreciate during the term of the trust. Asset growth must exceed the ‘hurdle’ interest rate set by the IRS for the assets remaining in the trust above the amount of the initial taxable gift to be transferred tax free at the end of the term.
4. You can afford to permanently give assets away. A GRAT is an irrevocable trust. Even though you will get back a portion of the assets you put in via the annuity payments, the assets that remain in the trust at the end of the term will pass to your intended beneficiaries and will not be returned to you.

The tax benefits of gifting with a GRAT

The goal of a GRAT is to reduce the amount of gifted assets that will be subject to gift and estate tax.

Here’s how it works:

1. As the grantor, you fund the GRAT by making a gift of stock or other assets you believe will appreciate.
2. You retain the right to receive annual annuity payments from the trust (usually a combination of shares and cash).
3. You retain the right to have the GRAT assets return to your estate if you die during the initial trust term of years
4. At the end of the term, those assets remaining in the trust that are above the amount of the original gift are transferred to your intended beneficiaries tax free.

A metaphor useful in describing GRATs is comparing the trust to a bag of water. The grantor fills the bag with water. The annuity stream coming back to the grantor is like a hole in the bag of water. At the end of the initial term, whatever is left in the bag of water (including the appreciation) passes to the beneficiaries.

Reducing the taxable amount of your gift

Let’s use a simple example to illustrate the benefits of a GRAT in your wealth transfer planning. Assume that you place $1 million worth of assets into a 10-year GRAT that is set up to pay a 5% annual annuity. At the official IRS interest rate in effect in August 2024 of 5.2% (known as the Applicable Federal Rate or the “hurdle rate”), the IRS would expect about $600K to be left in the GRAT after 10 years. That lower number becomes the amount of the gift you have made – not the original $1 million you put into the GRAT.

The goal is for the assets inside the GRAT to grow more than the hurdle rate. So, if we assume the assets inside the GRAT generate 2% of income and 6% of appreciation over the same 10-year period, over $1.4 million will be left in the GRAT at the end of year 10. In this case, you would be able to transfer $1.4 million to your beneficiaries and only pay gift tax (or consumed applicable exclusion amount) on $600,000. Slightly over $800,000 of wealth will have moved from one generation to the next without being subject to gift or estate taxation.

Why not just gift assets outright?

Ultimately, a GRAT provides several benefits versus gifting those same assets outright to your beneficiaries:

• Tax efficiency. A GRAT can reduce the taxable amount of your gift (as in the example above), whereas an outright gift will be taxed at the face value of your gift.
• Control. With a GRAT, you retain income through annuity payments during the trust term, while outright gifting immediately transfers the asset and its control to the beneficiaries.

• Income is taxed to you, not your heirs. With a GRAT, all income gains and losses will flow back to you as the grantor and be included on your personal income tax return. This allows more wealth to shift to heirs, because neither they nor the trust will have income tax responsibility. When you pay the income tax, that is not considered an additional “gift” to the GRAT, so the trust is not impacted. In other words, the assets held in the GRAT are not eroded by taxes, thus making it easier to outperform the hurdle rate. Also, because you are paying the income tax, the GRAT will not need to apply for its own tax identification number, unlike some irrevocable trusts that act as their own taxpayer.

Risks associated with a GRAT

There are some circumstances that will result in a failed GRAT. Even if these occur, you are generally no worse off than if you had not set up the GRAT in the first place.

• Lack of asset appreciation

If the assets don’t outperform the hurdle rate, the original value of the assets will be returned to you over the period of the trust. In this case, there would be no appreciation to pass to your heirs. In other words, if the income from the GRAT assets is insufficient to pay the annuity stream, then the GRAT must pay out an amount of trust principal sufficient to cover the gap, typically by selling the assets in the trust. It’s as if the bag of water has sprung another leak. The trustee is prohibited from using a promissory note to satisfy the required annuity payment from a GRAT, and a GRAT also must prohibit additional contributions to it.

• Dying early

Mortality risk is frequently cited as the primary drawback to GRATs. If you don’t outlive the initial term of the GRAT, the GRAT assets will be returned to your estate at the end of the term. It’s as if the GRAT never existed. On the plus side, the assets in the GRAT, and any appreciation on those assets, will be included in your estate for capital gains tax purposes which may go a long way to offsetting the increased estate tax amount. And, in the long run, all you have lost is the opportunity to apply your discounted applicable exclusion amount to a different wealth transfer, along with the attorneys’ fees paid to create and maintain the GRAT.

• Legislative action

For over a decade, US Treasury officials have proposed that GRATs be limited to terms of 10 years or longer. In essence, the Internal Revenue Service wants you to have more skin in the game by incurring more than a nominal amount of mortality risk (e.g., GRATs with 2-year terms). To date, no legislation has passed, but it remains a possibility.

GRATs can be an effective estate planning strategy

The basic wealth transfer principle at work here is – if the assets in the GRAT outperform the IRS hurdle rate, the trust is a “winner” from a wealth transfer standpoint. Phrased alternatively, to the extent that an investment return can be earned that is greater than the Applicable Federal Rate, wealth will be transferred to the next generation free of transfer tax.

A GRAT can be a powerful estate planning tool for transferring wealth to your beneficiaries without paying gift or estate tax. While a GRAT may not be the best option for everyone, if you are subject to estate tax and have assets that are expected to appreciate significantly in a relatively short period of time, it is worth considering.